Due Diligence

Due diligence is an analysis and appraisal of an entity, in preparation for establishing a relationship with that entity which involves business risk.

The objective of a due diligence exercise is obtain a greater understanding into the different aspects of the business that one is investing into. Scope and extent of diligence vary greatly depending on the purpose for which the investigation is undertaken. Even when the purpose is well defined, the extent of the investigation that is required is based on the size and relative significance of the acquisition target, price, availability of time, risk exposure, availability of financial information, etc. In hostile takeovers particularly, the ability to collect internal information of the target may be limited and this makes the task even more difficult.

Management research has shown that more than one half of acquisitions have not achieved the desired objective. Mistakes though always expensive could sometimes prove disastrous both from an economic as well from an operational stand point. This is because many acquirers operate under the theory that once the handshake has taken place, the deal is done. On the contrary, the work has just begun and it is time to investigate whether the deal is as good as it looks on the surface. And therefore in order to obtain a comfort that what is represented during preliminary discussions is true a due diligence is required. Especially in a restructuring exercise diligence gives a complete perspective of the company which assists in taking an informed decision while deciding on the structuring to be adopted for the transaction.

There is no statutory requirement which calls for a due diligence to be undertaken prior to any of the above mentioned transaction. However, as a policy of good corporate governance and in many organizations as a pre requisite guided by internal policies a due diligence needs to be undertaken prior to the consummation of any transaction.

A due diligence would reveal various facets in an organization which would be considered at the appropriate instance in the exercise. For eg in case a company has two divisions of which one of it is not a profitable proposition the investor might ask for a demerger of the non profitable venture and invest only in the profitable unit. There are various other such matters from a legal, tax, financial angle that are revealed in the course of the exercise.

There is no magic formula to guarantee the acquisition of a company at a realistic price, let alone to ensure success afterwards. However, due diligence aids to enhance the chances of success.
It is a general misconception that due diligence is just a formality and a less important step in any acquisition process. With this misconception many buyers have suffered severe financial losses by proceeding on the basis of inadequate information and half-truths. External events not under the control of the acquirer or investor are often blamed for these poor performances. However, in most cases due diligence carried out in the right earnest would have identified the potential impact of these events well in advance. Thus their impact could have been avoided or, at the very least, minimized.

Any successful business has different areas of operations and their smooth and efficient co ordination is the recipe for the success of the business and therefore a business diligence covers majority of the operations of the company. Each of these areas has to be looked into individually to ensure its effectiveness and relevance. Each of these area explained with its scope as follows:

TECHNICAL DILIGENCE:

• As the name suggests it’s a diligence of the technical facilities in an organisation and becomes more relevant for a manufacturing undertaking. The objective of technical due diligence, in such cases, is to assess the capabilities of the target’s plants in terms of productivity, technology and equipment life.
• The buyer usually obtains access for its engineers to the factory buildings of the seller. They make on the spot assessment of the seller’s business operation and give their comment on the buildings, machinery, equipment and processes, as to whether they are efficient for the long haul or are in need of substantial overhaul. It is not unusual for a seller to inform the buyer about the substantial capital outlays to be made after the acquisition in the form of new factory buildings or expensive equipment. These reviews, however, are often carried out in-house, except in the case where an independent valuation is required. Such capital outlays, if necessary, may convert an otherwise profitable acquisition into one an unprofitable one given the additional cash investments required to be made by the buyer.

HUMAN RESOURCE DUE DILIGENCE:

• One of the key components in any acquisition is the people associated with the target company; their relationships, expertise, leadership quality and finally their ability to manage the surviving entity. It is important to assess their qualifications, as well as the likelihood of them remaining with the merged company. To achieve these objectives a human resource due diligence is undertaken. The investigation becomes the most critical diligence in sectors where human resource is the backbone of the organisation, for example, in software, consultancy, research related fields.
• The human resource review provides both, qualitative and quantitative, outcomes. While qualitative results are in terms of assessment of resource requirement and capabilities, the quantitative results are more in terms of ascertaining the liability towards ‘”Golden parachute” and “Golden hand shake” which influence the ultimate value of the potential acquisition.

LEGAL DUE DILIGENCE:

• Legal due diligence is undertaken with the following objectives :
  • To assess the impact of ongoing and potential litigation and also those of recently concluded litigation,
  • To ensure that the target company has complied with the provisions of all relevant statutes and there are no potential liability on account of non compliance,
  • To assess the legal validity and implications arising out of contracts entered into by the company with third parties.
  • To assess the current and anticipated future impact of government regulations on the entity’s cost level,
  • To assess the legal problems that may arise in merging the two legal organisations and analyse them. This is important if the target entity has cross holdings or has multiple joint ventures in different countries.
• However, the nature of the seller’s business will play a major role in the area the lawyers choose to investigate in detail. For example, if the target company’s business is mainly driven by technology or research then legal investigation should give a special emphasis on issues of propriety rights and patent. In addition, the lawyer should give careful consideration to the mechanics of the acquisition which also influence the direction in which the investigation should take place.
• Generally, the services of an independent agency is used for carrying out a legal due diligence. However, for the purpose of dissecting and evaluating the commercial aspects of the business in the right earnest the reviewing team should include at least one commercial person. This would facilitate ease in the understanding of the impact of regulations from a cost stand point.

ENVIRONMENTAL DUE DILIGENCE:

• Given the increasing awareness towards environmental issues and the significant increase in laws governing the same many organizations strive to achieve and demonstrate sound environmental performance. They take into account environmental policies formulated by the government and the measures taken to minimize the impact of their activities, product or services on the environment.
• In order to evaluate the compliances of organizations to the environmental laws governing them conducting an environmental due diligence or audits has become imperative. The objective is to obtain assurance that the environmental performance of the organization meets and will continue to meet the regulatory requirements.

SYSTEMS DUE DILIGENCE: 

• System due diligence is undertaken to ensure the proper management and adequate security of the data/ information systems. The process involves :
  • Review of IT security policy and procedures,
  • Inter & intra location network review,
  • Review of software applications and operating systems, and
  • Review of disaster recovery and business continuity plans.
• The result of the due diligence has got a direct bearing on determining the value and viability of the acquisition/ investment. The report normally outlines the current status of IT adopted, its scope, investment required for improvement and post investment/ acquisition action plan. The investment requirement is determined after considering the desired return on IT investment.

TAX DUE DILIGENCE: 

• The analysis of various taxes levied is one of the most complex areas that are encountered during an investigation. It is recommended that a tax expert, highly qualified in the entity’s industry, be retained in the investigation team.
• The objectives of a tax due diligence are :
  • To analyze the impact of unpaid taxes/ contingent liability against the target,
  • To assess the likely impact of results of the current and potentially pending litigation and result of recently concluded litigation,
  • To assess the liability towards deferred taxes, and
  • To analyze the future tax implications in respect of the potential acquisition.
• Tax due diligence is one of the important determinants of the value of the acquisition. In the restructuring and mergers of companies under same group, tax consideration is one of the “make or break” issue, and significantly influences value determination.

FINANCIAL DUE DILIGENCE:

• Financial due diligence is the most important part of the investigation exercise and is undertaken for all sorts of investment propositions, viz., financial and strategic investment, restructuring, lending and public offerings. The outcome of financial due diligence directly influences the value of the acquisition. It is observed that more than 60% of the revision in value from the first negotiated price is on account of the outcome of findings made during financial due diligence.
• The financial due diligence should be conducted with the aim to address two objectives. First, to establish the veracity of disclosed financial statements and second, fairness of accounting policies.
• The second objective of the accounting investigation is an important factor in helping the businessman to determine the desirability of the acquisition and price. Given the number of different principles applicable to each specific financial situation, moreover the judgment factors involved in the ultimate selection of the principles provide such a broad range of possible different profit and loss and balance sheet results in the same business, that a change in the particular generally accepted accounting principles may on paper cause a low profit business to appear highly profitable.
• Financial due diligence extends to more than just financial numbers reported in the financial statements, any financial diligence should encompass business review as well and an detailed discussion with the management of the company. Again depending upon the nature of the industry and acquisition driver the focus area is determined. Focus area in a financial diligence could range from Profit and Loss to Balance Sheet to mere agreements review.
• Extent of financial due diligence is also influenced by the kind of transaction for which the diligence is being undertaken. For eg in case of strategic acquisition the diligence is primarily financial statements vetting whereas in case of a private equity there is business side also which needs to be dwelt into.
• Although each type of due diligence is largely autonomous, the results should be co-ordinated. A tendency exists to conduct the due diligence of the seller (in each of the areas mentioned) as isolated exercise. For a due diligence to be successful, this shortcomings need to be overcome.

Yes, due diligence is an investigation into the historic performance and acts of the company, therefore, the extent to which history needs to be dwelt into and the level of investigation is determined by the type of transaction. It would be different for a business acquisition as compared to a financial investment as compared to a demerger. We outline the broad difference between these cases:

Acquisition: 
In an acquisition the shareholders of the target would be exiting the company in toto and the incoming investor is generally looking at the transaction from a strategic view point. Therefore the diligence would have to be conducted with a view to assess the likely impact on business operations as a result of the exit of target shareholders (impact on customers, suppliers, employees etc.,). Further, given that it is a strategic transaction the focus should be to identify areas which overlap with the investing company and find out ways to work around the same.

Financial Investment:
As the name suggests it’s a financial investment made with an objective to make financial gains by selling the stake in the company after a particular period. Given that the investor has a short term view the focus is on the business aspects and the growth plans expected by the management. Historical numbers are looked into to corroborate the numbers used in the financial model used for the purpose of arriving at the deal value.

Demerger: 
In case of a demerger diligence the assets and liabilities that should be transferred in the course of demerger are identified and any other potential liability that may arise in the course of demerger. Another area is identification of the structuring for the demerger to be adopted after careful evaluating the impacts under the different scenarios.

Due diligence are conducted either by external agencies or as in cases by the acquiring companies own team. The most important factor for any successful diligence is an in depth understanding of the business of the target and laws and other provisions that regulate the targets business and thus any person appointed to carry out diligence must have these basics covered other educational qualifications vary for the different types of exercise.

Due diligence is a two way process and one of the most challenging aspect in a diligence exercise is to the get the target talking about the short comings of the target. Since they are aware that the objective of any diligence exercise is to find the matters which affect the company rather than focus on its strength the target company would do its best to reveal only the positives. Here is where the skill of diligence person would be tested as he would have to extract all kinds of information about the target and he should use both internally and externally available information to achieve this objective.

Due diligence is primarily of two kinds buy side diligence and sell side diligence. In a buy side due diligence the exercise is carried out on behalf of the potential buyer on the target (investee company) by experts are appointed by the buyer and the deliverable in form of a report is also issued to the buyer. Sell side due diligence is when the due diligence exercise is carried out by the investee company on itself and the outcome in form of a detailed report is then shared to the interested parties. The later is referred to as vendor due diligence and is a preferred options when there are more than one interested parties.

The stages in a diligence exercise could be broadly divided into two stages — preliminary investigation and conclusive investigation.

PRELIMINARY INVESTIGATION – Diligence from publicly available information:

• Preliminary investigation also known as business due diligence, is undertaken primarily to assess the commercial feasibility and the synergy emanating between the organisations (acquirer and target). The target’s business potential is estimated by evaluating its brand value, distribution system, market share, profitability and other economic considerations.
• Obtaining these detailed requires one to tap the secondary resources for obtaining information from off-site locations. Meeting competitors, distributors, bankers and material suppliers are some of the ways employed by the acquirer to get a feel about the target’s competitive business strength and financial standing in the market.
• It is difficult to state at which stage the investigation should be regarded as complete, there is no definite answer. But when one can comfortably make a firm recommendation either not to proceed further, or to start deal negotiations; that would be the ideal time to bring the review to a close. If the outcome be positive it is essential that the understanding agreed upon be reduced in writing either through a MOU or other like agreement with the target company. Such an agreement will give the target a sense of confidence about the intentions of the acquirer and will lead him to co-operate and share further information required to conclude the investigation. The agreement, however, should include a preliminary negotiated value of the acquisition based on the representations made by the target and also a list of key actions and investigations that will need to be undertaken for completing the acquisition.

CONCLUSIVE INVESTIGATION – After entering into a Term Sheet or similar form of an agreement 
This investigation is nothing but verifying the company’s representation and justifying the value of the acquisition as agreed in the preliminary negotiation. The verification involves examining various facets of the business such as technical, legal, environmental, tax, human resource, technical, system and accounting, the emphasis of which can change depending on the critical business factors. 

APPROACH & METHODOLOGY:

• Approach in due diligence
  In connection with any merger or acquisition, the two merging entities or the purchaser should “kick the tires” to ensure that they are getting what they expect. Thus, the approach of the due diligence can vary considerably, depending upon the nature of the target, the structure of the acquisition and the level of comfort desired. However, it takes only a small oversight to reverse the economics of an otherwise attractive acquisition
• While there are many principles important in the due diligence process, four are important in designing a proper approach. That is:
  • Begin the process prior to negotiations Most sellers want the due diligence process to be conducted in a discreet and efficient manner. Few companies want their employees or the public to know that they are undergoing acquisition discussions. Accordingly, it is important to act quickly and in a co-ordinated manner.
    Before a specific target is identified, a generic programme should be developed that specifies the business purpose of the acquisition, critical goals and objectives, business units which are likely focal points in addition to the other uniform procedures that need to be undertaken virtually in any acquisition. While the procedure must be modified and tailored to the target, one may risk overlooking critical steps if they are developed in isolation.
  • Bring in the right people It difficult to find the set of persons who have the breath of knowledge to carry out a thorough due diligence investigation — particularly if time is of essence, as it always seems to be. Therefore inadvertently most of the big companies have their own due diligence team as a part of the acquisition advisory team.
    Few firms have all the resources to evaluate a potential target. Therefore in a typical due diligence team, there are representatives from the acquirer, external legal counsel, public accountants and other specialists.
    If the team approach is adopted, it should consist of individuals with the right combination of experience and professionalism suitable to the task.
  • Move down the decision tree in a coordinated manner Time is of essence in any acquisition process therefore any due diligence team must bring the proper resources to the table at the appropriate time. It is most likely that several people would be analyzing different components of the company at the same time.
    When arrangements have been made to perform due diligence procedures, the team should be notified of the desired level of their involvement, simultaneously the target should be notified of who will be involved in a preliminary planning meeting. At the planning meeting, the team leader, accountant and external counsel normally are present to lay out the assigned responsibilities. At this meeting, the scope and structure of the acquisition should be discussed in detail, and all parties should agree on the documents to be produced, personnel to be made available., the time table for completing each step, and a framework for following up on open issues.
  • Document findings succinctly and efficiently Rarely is the due diligence team, the only party interested in the findings. Internal and external counsel, finance and accounting department and senior management frequently have follow up questions and need additional information on short notice to make informed decisions. Specific criteria should be established as to what, and how, such information will be collected and retained. It is necessary to have a pragmatic approach, including an indexing system, to document conversations, material received, and analysis performed.

Due diligence methodology is to be customised according to the needs of the client, type of transaction, nature of review and time availability. However, there are four standard steps in any due diligence methodology.

• Understanding the clients needs
  • The first step in any methodology is to "read the client". Understanding of the client's intention in the potential transaction is essential.
  • A buyer generally looks beyond the degree of symmetry between the organisations (acquirer and target) that will lead to further penetration of existing client markets. He may also look to understand the target's ability to open additional markets — new geographic locales, segments with unique service requirements or other differentiating characteristics that have previously kept these markets beyond the acquiring organisation's reach.
  • Based on the understanding of client needs, the objectives of the due diligence are reset and the scope is altered accordingly.
• Ask pertinent information
  • The objective of the investigation will determine the breadth and depth of information required.
  • Prior to commencing the on-site due diligence, a list of pertinent information should be requested from the target company, (in some cases, information also is requested from the acquirer for reciprocal due diligence).
  • While each acquisition is different, some information is uniformly necessary to evaluate any investment decision, for example, financial statement, personnel list, customer profiles etc.
  • One can readily anticipate the reaction of a potential seller of a business, if confronted with a request to provide detailed information on all transactions/aspects of the business.
  • Therefore, it is vital to prioritize the information requests and determine the appropriate member, or members, of the due diligence team to obtain the information.
• Focusing on "Make or Break" issues.
  • The due diligence process has been likened to peeling a blemished onion. You investigate one layer at a time. Each phase of the investigation, uncovers additional items to be explored further. You then move on to the next phase — and the next — until you reach a conclusion as to whether to continue or to abandon the investigation. However, this costs lot of time.
  • Thus, it is important to identify well in the beginning those areas which underpin the purpose for the acquisition and therefore, the purchase price.
• Periodically holding review meetings
  • The engagement leader must schedule frequent meetings with the due diligence team. The primary objectives of these meetings are :
    • To obtain status reports from the team members on their progress,
    • To determine when it becomes appropriate to redirect, cancel or otherwise change the course of the investigation,
    • To determine whether it is appropriate to assign additional personnel to accelerate the effort,
    • To determine if it is timely to bring in outside expertise. For example, if lax experts have not been part of the original team, is it time to obtain their assistance, and
    • When is it appropriate to formalise the results of the investigation in a report, to the appropriate of the management.

The outcome of a diligence is once again decided by the objective of the exercise, however, the most common outcome is the acquirer has conducted a detailed exercise to obtain comfort on the details and he is in a position to take a more informed decision whether to proceed with the deal or not and at what value in light of the information received.

The outcome would be evaluated against its achievement of the goal it was set out for. If the diligence gives the acquirer the insight he sought out to achieve the diligence process could be categorized as a successful diligence. In some quarters it is believed that the success of a due diligence firm is to be measured by giving more importance to the number of deals that have failed on account of findings from a due diligence rather than by the number of successful deals.

The final product of a due diligence is reported in form of issuing a report which of findings which summarizes the observations made with the description of its likely impact and recommending the measures to be taken to prevent or improve the situation.

The observations of a diligence are considered in a negotiation process and a way is sought to be found out around the issues. It could be in form of decreased valuations, indemnity in case of happening or non happening of an event, commitment etc.

The time line is once again affected by the extent of diligence, types of diligence, availability of information. There are diligence which have been completed within a fortnight while there have been cases on the other hand which have run into a few months and in a few cases even years.

Diligence exercise is normally carried out either in the form of full scope due diligence with complete access to management or in form of data room/ site with limited management access

Full Scope diligence with unlimited access to management:

In full scope diligence the company has access to both management and data simultaneously and the extent of data availability is not restricted to selected information as in case of a data room.

Data room/ site:
In case of data room assignment selected information is compiled before it is made available for a review. The information is organized in files and then shared with the diligence team, depending upon the extent of data periodical meetings with the targets management is arranged to solve the queries raised by the diligence team. A deviation from a data room kinda situation is the setting up of data site wherein all information is electronically uploaded onto a site from where generally only viewing is allowed data cannot be downloaded. The data site details and password are shared with the diligence team and similar to data room periodic meetings are facilitated to solve queries. Generally data room and data site is facilitated when there are multiple bidders in order to save on time taken by each bidder for review of information. Data room and data site are typically available for a limited period of time during which the diligence exercise is expected to be completed.